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Research Journal of Finance and Accounting                                                                        www.iist...
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Applicability of the synchronized models of modified current and historical cost accounting methods on the reported profits


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Applicability of the synchronized models of modified current and historical cost accounting methods on the reported profits

  1. 1. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 2012 Applicability of the Synchronized Models of Modified Current and Historical Cost Accounting Methods on the Reported Profits SUNDAY A. EFFIONG Department Of Accounting, Faculty Of Management Sciences, University Of Calabar –Calabar, Nigeria. +2348037115127AbstractThis study examines the applicability of the synchronized models of the historical cost method and the modifiedcurrent cost method for financial reporting. Based on the inherent deceitful and irrelevant nature of the historical costmethod during periods of rapid price changes and the glaring complex and subjective nature of the current costmethod, this study develops models which combine objectivity, noticeable in the historical cost method, withrelevance obtained from the current cost method while minimizing the deficiencies inherent in the two methods. Fourmodels were synchronized based on historical cost and current cost data which resulted in the development of themodified accumulated depreciation adjustment (MADPA); modified cost of sales adjustment (MCOSA); modifiedmonetary working capital adjustment (MMWCA) and modified gearing adjustment (MGA). The study revealed thatthe models when applied to the financial statements will bring about ∆FAV (change in fix asset valuation), ∆SV(change in stock valuation), ∆SFV (change in shareholders’ fund valuation) and MCCR (modified current costreserve). Based on these results, the study recommended that financial statements should be prepared on the bases ofrelevance, reliability, objectivity, understandability and comparability, especially during periods of changing prices,by applying the synchronized models developed in this study. These models remove the technicalities of ordinarycurrent cost accounting method and retain the objectivity of the historical cost method. With the modified models,financial statements are objective, relevant, reliable and understandable during periods of changing prices.KEYWORDS: Synchronized Models, Accounting Methods, Modified Current Cost Method, Historical CostMethod, Price Level Changes, Reported Profits1.IntroductionThe existence of inflation and its persistent nature calls for an alternative to the historical cost accounting method ofprofit reporting. One feasible alternative to the historical cost accounting method is the current cost accountingmethod. Traditionally, accounting measures profits by comparing sales with cost of sales and overheads measured attheir historical costs (Goudeket, 1990). This method is often referred to as the historical cost accounting method.However, in recent years when a rise in the general level of prices of over 25% (CBN, 2005) is experienced, theprofession has recognized the need for some amendments to the historical cost accounts. This measurement approachreduces the operating ability of the company and does not maintain the capital of the firm. Current costaccounting method has, as a basic principle, that operating profits should only be measured and reported after thecapital of the firm had been maintained,( Dean, 1994). The emphasis on capital maintenance is highly imperative intoday’s business environment if the business must survive and succeed.The need to maintain the operating capital of the firm intact has made companies and Stock Exchanges to bemore concerned about the depleting nature of the shareholders capital resulting from the eroding effect of thehistorical cost accounting principle. The historical cost concept of accounting has ignored or has not provided for anyfeasible measure of reflecting the dynamic nature of business transactions, vis-à-vis changing prices. In periodsof inflation, the historical cost principle measures profits to the extent that only operating assets in monetary termsare maintained. This measurement approach ignores the preservation and maintenance of operating assets the waythey should be in real terms. 127
  2. 2. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 2012This subjective approach has led different users of accounts to have different views from a given set of accounts.Cases where companies subjectively revalue their assets and equally create an equalizing reserve (e.g. Revaluationreserve) is a clear indication of the deficient nature of the historical cost accounting method of reporting profits.Capital cannot be maintained in isolation of the principles, concept and postulates employed in the measurement ofthe business income. Since the income of the business directly affects the shareholders capital, it therefore followsthat the methods employed in measuring the income equally directly influence the value of the shareholders’ capital.Historical cost principle of accounting is objective and easy to apply and understand. This is true in periods ofrelatively stable prices. In periods of changing prices, this method of profit reporting becomes grossly deficient as itoverstates profits and thus does not maintain the operating capabilities and operating capital of the firm. Current costprofit is quite suitable and maintains operating capabilities of the firm in periods of changing prices. This method ofprofit measurement has however been reluctantly adopted because of the seeming subjective nature of indexation andconversion methodology of historical cost assets to their current cost status. This, in many occasions, has causedmany users of account not to rely completely on current cost values of transaction in the books of account. Currentcost method is also accused of being highly complicated and technical in terms of computation.The paper aims at developing a modification to current cost accounting method with the intent of eliminating thecomplexities and subjectivity inherent in it while retaining the objectivity inherent in the historical cost method. Thispaper demonstrates the applicability of the modified current cost accounting and the synchronized models ofhistorical and current cost principles on the reported profit. The paper equally evaluates the impacts of the modifiedcurrent cost accounting on reported profits.2. Theoretical BackgroundUsing historical cost method, assets and expenses are entered into the books of account at their actual cost to thebusiness. This method is objective and verifiable. It equally provides a universal, consistent and simple method ofrecording assets and reporting profits. The historical cost concept focuses on safeguarding assets rather thanpresenting measurements useful for decision making clearly. Financial reports are intended to provide somesafeguards against the misuse of assets by managements and also provide measurement to shareholders indicative ofthe efficiency with which assets have been employed, (Effiong, S. A., Udoayang, J. O. and Akabom, I. A., 2011).Conventionally, financial reports prepared on historical cost basis are expected to be relevant, objective,understandable and feasible. It is however glaring that in applying the criterion of relevance to financial reportsprepared on historical cost basis, users’ information need is not met. The criteria of feasibility, objectivity, ease ofunderstanding and cost of implementation are considered satisfactory in historical cost method.The historical cost method measurement of profit by comparing sales with costs of sales and overheads (measuredat historical costs), is objective and works well in periods of relatively stable prices. It however does not workwell during periods of changing prices.In the balance sheet, business assets have values placed on them and there are several possible ways of finding abasis for valuing these assets. Here are three possibilities. - What the asset could be sold for if sold as an asset. 128
  3. 3. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 2012 - What the asset could be sold for if sold for some other uses - What was originally paid for the asset during its acquisition The first and second possibilities may seem useful at first sight but figures can only be obtained by formingopinions, making estimates or simple guessing. This can make the figures subjective whereas accountants prefer tobe objective. Thus, the last possibility is preferred because of its objective status. Meigs (1998) sees current costaccounting as a valuation concept which combines the concepts of replacement cost and net realizable value indetermining whether selling (exit) or buying (entry) prices should be used for the purpose of establishing the value ofan asset to the business. Of all the alternatives to historical cost a counting, current cost accounting is seen by IFRS(2004) as the most reliable and viable basis of profit measurement in periods of price changes. The relevance ofcurrent cost accounting informed its adoption by the accounting profession in United Kingdom, for dealing with theproblems implied in changing value of money in financial reports, (Gold, 1980). Gold further declares that theInstitute of Chartered Accountants of England and Wales adopted SSAP 16, which deals with current costaccounting for use by companies where historical cost accounts are materially affected by price level changes. Thereis need therefore, for shareholders to have information about the effects of changing price levels in order to fullyappreciate the current financial position of the company.Ross (1990) looks at Current Cost Accounting (CCA) as a methodology originally designed for financial reporting intimes of rapidly changing prices where historical cost accounting is considered inadequate. The FinancialAccounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS) proposed twoapproaches to current cost Accounting (CCA), which differ in their consideration of “capital maintenance”. Capitalmaintenance means the manner in which the capital of the company is viewed for determining profit (Miller,1991and Ross, 1990). Capital can either be viewed in operational term (company’s capability to produce goods andservices) or in financial term (the value of shareholder’ equity interests). Operating capital maintenance (OCM)concept requires the company to have as much operating capacity at the end of the period as at the beginning.Financial capital maintenance (FCM) considers that financial capital for the company is maintained in real term atthe same level as at the beginning of the period.Among the benefits of current cost accounting is the fact that it represents the amount the firm would have to paycurrently to obtain the asset or its services: therefore, it represents the best measures of the value of the inputs beingmatched against current revenues for predictive purposes. Current cost accounting equally permits the identificationof holding gains or losses, thus reflecting the results of asset management decisions and the impact of theenvironment on the firm not reflected in transaction. It permits the reporting of current operating profit, which maybe used to predict future cash flows. Current cost represents the value of the asset to the firm if the firm iscontinuing to acquire such asset.Disadvantageously, some objectivity has been lost in current cost accounting. Unless the assets currently sold in themarket are identical in all respect to the assets held, some subjectivity must be applied in transferring currentexchange price to the old assets. Another disadvantage is that the present value of the benefits to be provided by theasset may not be equal to the current or replacement cost of the asset, (Effiong, S. A., Udoayang, J. O. and Akabom,I. A. ,2011). 129
  4. 4. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 20123.MethodologyHistorical cost method of accounting is objective and simple to calculate and understand. It is however not relevantin periods of changing prices. During these periods, historical cost accounts become defective, deficient anddeceitful. Current cost on the other hand is relevant in periods of changing prices but it is highly complicated,technical to compute and subjective in application. To overcome the problems of these two accounting bases, amodified current cost accounting is proposed in this study. This will eliminate the complexities inherent in currentcost accounting and retain the objectivity of the historical cost method.Many developing and developed countries have met resistance and problems of implementation in the process ofapplying current cost accounting for financial reports. This paper develops simplified models for ease of applicationof current cost accounting. The following procedures are required for the application of the modified current costaccounting. • It is published together with the historical cost financial statements to show, on a comparative basis, the effects of inflation on historical cost accounts. • Monthly price movements are obtained from the Federal Office of Statistics for changes in prices of goods and services. • Creditors are restated using the lending rate while debtors are restated using the savings rate at the balance sheet date • Current cost reserve is obtained from the reserves in the modified current cost balance sheet. • Depreciation is calculated on the adjusted value of fixed assets. • Dividends are paid from the profits of the modified current cost accounts • Taxes are calculated on the modified current cost profits of the year3.1 Synchronized Models for the Modified Current Cost Account The seven major areas requiring adjustments for the modified current cost accounting are as follows: Indexation conversion (IC) Depreciation adjustment (DPA) Accumulated Depreciation adjustment (ADPA) Cost of sales adjustment (COSA) Monetary Working Capital Adjustment (MWCA) Gearing adjustment (GA) Modified current cost reserve (MCCR)3.1.1 Indexation ConversionConsumers’ Price Index (CPI) is used in the revaluation of all items of the financial statements affected by pricechanges. The CPI is converted to current cost index using the model below: 130
  5. 5. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 2012 IABD x HCA = MCCA IABY Where: IABD = Index at balance sheet date IABY = Index at beginning of the year HCA = Historical cost accounts MCCA = Modified current cost adjustment, ( Effiong, 2008).3.1.2 Depreciation AdjustmentDepreciation adjustment required for the modified current cost accounts is derived from the adjusted historical costdepreciation to current cost depreciation. The model for the depreciation adjustment is as follows: DPA = DR X HCFA x IABD - HCD IABY Where: DPA = Depreciation adjustment DR = Depreciation rate HCFA = Historical cost of fixed asset IABD = Index at Balance sheet date IABY = Index at beginning of the year HCD = Historical cost depreciation. ( Effiong, 2004)The model for the modified current cost depreciation adjustment is given as MCCDP = DR (CCFA) Where: MCCDP = Modified current cost depreciation CCFA = Current Cost of Fixed Asset.3.1.3 Accumulated Depreciation AdjustmentThe total depreciation charged from the time the asset was bought is adjusted as follows: ADPA = IABD x HCA D IABY Where: ADPA = Accumulated depreciation Adjustment HCAD = Historical cost accumulated depreciation. ( Effiong, 2008)The model for the modified accumulated depreciation adjustment is given as: MADPA = ADPA + MCCDP Where: MCCDP = Modified Current Cost Depreciation MADPA = Modified Accumulated Depreciation Adjustment 131
  6. 6. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 20123.1.4 Cost of Sales Adjustment Cost of sales is adjusted using the model below: CCOS = HOPS IABD + Ps – HCS IABD IABY IABY Where: CCOs = Current cost of sales HOPS = Historical cost of opening Stock HCS = Historical cost of closing stock PS = Purchases for the period. ( Effiong, 2004)This model is modified as follows: CCOPs + Ps – CCCs = MCOSA Where: MCOSA = Modified Current cost of sales CCOPs = Current Cost of opening Stock CCCs = Current Cost of Closing Stock3.1.5 Monetary Working Capital AdjustmentMonetary working capital is adjusted as follows: CCMWC = CMWC AI) - OMWC AI IABD IABY Where: CCMWC = Current cost monetary working capital CMWC = Closing Monetary working Capital AI = Average Index OMWC = Opening monetary working capital. ( Effiong, 2008).The modified model which synchronizes current and historical costs monetary working capital is given as: MMWCA = CCCMWC -CCOMWC Where: MMWCA = modified monetary working capital adjustment CCCMWC = Current Cost Closing Monetary Working Capital CCOMWC = Current Cost Opening Monetary Working Capital3.1.6 Gearing AdjustmentThe model for the mix between historical and current cost gearing is given as: MGA = L MCCDP + MCOSA + MMWCA L+S Where: MGA = modified gearing adjustment 132
  7. 7. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 2012 L = creditors falling due after one year S = Shareholders’ Fund MCCDP = modified current cost depreciation MCOSA = modified cost of sales adjustment MMWCA = modified monetary working capital adjustment.4. ResultsThe summarized models which harmonize objectivity with relevance of financial reports are presented below. Theseare the basic objectives of financial reporting.The models minimize the technicalities of the current cost accounting method. The formats for the simplified modelsare as follows. MCCDP = DR (CCFA) MCOSA = CCOPs + Ps – CCCs MMWCA = CCCMWC - CCOMWC MGA = L MDPA + MCOSA + MMWCA L+S4.1 Modified Current Cost Reserve (MCCR)This reserve is created to take care of all the adjusted items in the financial statements. The reserve created in thispaper is made up of: - Modified current cost adjustments (MCCAs) as shown in the summarized presentation of modified current cost. - Fixed asset Valuation (FAV) - Stock Valuation (SV) - Shareholders’ Fund Valuation (SFV) The creation of MCCR is based on changes in items above. The changes are presented as follows: ∆FAV = MCCFAV - HCFAV ∆SV = MCCSV - HCSV ∆SFV = MCCSFV - HCSFV MCCR =MCCA + ∆FAV + ∆SV + ∆SFV Where: 133
  8. 8. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 2012 FAV = Fixed Assets Valuation SV = Stock Valuation SFV = Shareholders’ Fund Valuation5. DiscussionsThe study looked at empirical models which combines relevance with objectivity in financial reports. Historical costmethod is seen to be deficient and thus not relevant in periods of changing prices while current cost method is seen tobe subjective and complicated in application. These two accounting methods are however accepted for objectivityand relevance respectively to historical and current cost methods.The study presents models which harmonize the acceptable qualities of the current cost method with those of thehistorical cost method in drawing up financial reports. These significant and empirical models are capable ofneutralizing the deficiencies inherent in the historical cost and current cost accounting. The measurement base of anyfinancial transaction greatly determines what figure is reported as net profit. During periods of increasing prices,historical cost method will normally undermine the operating capabilities of the company by overstating the valueof the net profit. This is due to the consideration of depreciation charges on very old values of asset and the paymentsof dividends and high taxes on overstated profits. Current cost method charges depreciation based on a very recentcost of the assets and as such profits are not overstated and dividends and taxes on based on results obtained fromcurrent values of transactions. The synchronized models ensure the maintenance of the operating capabilities andoperating capital of the firm.The deficiencies in the measurement of profits become very prominent during periods of changing prices where thevalue of today’s naira cannot be reasonably compared with the value of the naira tomorrow. This rapid erosion in thepurchasing power of money exerts equal eroding effect on the firm’s operating capabilities. If profits are notmeasured in a way that figures are not overstated, the real value of the operating capability of the firm’s capitalcannot be maintained. Mclntyre (2007) concluded in his study that profit obtained from historical cost method isoverstated while current cost method of reporting profits based on current circumstances of the firm’s operations iscomplex and difficult to apply. Hendrickson (2006) came out with the conclusion that during periods of increasingprices, current cost financial statements should be published alongside historical cost financial statement since thereported profits and balance sheet figures of these two methods bear different weights on the operating capabilities ofthe firm’s capital. 134
  9. 9. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 20126. ConclusionThe synchronized models overcome the inherent complexity of current cost accounting computation and retain theobjectivity of historical cost accounting. The application of these models injects reliability, relevance, objectivity,comparability and understandability into financial reports prepared during periods of price changes for the purpose ofshowing the effects of inflation on transactions of the firm. Investors and shareholders’ confidence aresecured during periods of changing prices with the application of the synchronized models to every transaction in thefirm.7. RecommendationsSince the reported profits significantly affect the operating ability of the firm’s capital, management shouldtherefore gear its efforts toward ensuring that profits reported are suitably adjusted for the effects of changing prices.The required adjustments must necessarily inject reliability, objectivity, relevance, understandability andcomparability into financial reports. An acceptable fact is that inflation has become persistent in our economy,transactions and accounts should be made inflation complaint to ensure that profits from such transactions donot undermine the value of capital.This is possible by publishing accounts which have been adjusted with the synchronized models of current andhistorical cost methods of financial reporting to lay bare before investors and shareholders the effect of inflation ontheir investments. The Securities and Exchange Commission should make inflation adjusted financial statements aprecondition for filing annual returns in the commission. Equally, the submission of accounts and financialstatements adjusted for effects of price changes should be made one of the conditions for firms to be listed in thestock market. It is not necessary to regularly inject capital or recapitalize the firm but it is sufficient to maintainthe original operating ability of the firm’s capital by applying the synchronized adjustment models on financialtransactions. Historical cost profits should have less emphasis but not abandoned while the adjusted profits shouldform underlying bases for corporate and investment decisions.ReferencesBeaker, W. and MAnigold, J (1995). Inflation and Current Value Accounting. Illinios: University of Illinois Press. 135
  10. 10. Research Journal of Finance and Accounting www.iiste.orgISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 9, 2012Berliner, R. W. (1993). “Do analysts use inflation-adjusted information? Results of a Survey”. EconomicConsequences of Financial Standards, Selected Papers 13, 7-10.Central Bank of Nigeria (2005) Monthly Labour Review. Bullion, 8, 56.Cockran, N. G. (1994). “On the Preformance of the Linear discriminant Function”. Technometrics 11 (5), 70-73.Dean, G. A. (1994). “The Stock of Fixed Capital in the United Kingdom in 1991”. Journal of the Royal StatisticalSociety. 127 (3) 142 -146.Effiong, S. A. (2004). Current Cost Profit Measurement as it Affects Corporate Capital. Nigerian Journal of Socialand Development Issues. 4(1), 121 – 133.Effiong, S. A.(2008). Historical cost Profits and the Capital of the Firm: An Evaluation of Current Cost Accountingas an Alternative Reporting Approach. Journal of Management and Enterprise Development. 5 (4), 112 - 127Effiong, S. A., Udoayang, J. O. and Akabom, I. A. (2011). ‘Correlational and Differential Influence of Historicalcost and Current Cost Profits on the Operating Capabilities of the Firm.’ International Journal of FinancialResearch. 2 (1), 64 – 70.Gold H. P. (1980) “Current Cost Accounting-the End of the Beginning” The Accounting Magazine 74 (4), 12-21.Goudeket, A. (1990) “An Application of the Replacement Value Theory”. Journal of the Institute of CharteredAccountants of Scotland 84 (7) 128-135Hendrickson, J. (2006). ‘The case against the separation of current operating profit and holding gains’ AccountingReview, 2 (1), 28- 35International Financial Reporting Standards (2004). Financial Reporting in Hyper Inflationary Economy.Washington DC. World BankMclyntre, E. W.(2007). “Interaction effects of inflation accounting models and accounting techniques.” TheAccounting Review, 53, (1), 45-49.Meigs, W. B. (1998) Intermediate Accounting Englewood, McGrawHillMiller, G. (1991). “A Simple Guide to CCA” Accounting, 92 (1) 1077 – 1082Ross, D. (1990).”Current Cost Accounts What do they Mean?” Accountancy, 93 (1), 1065-1068 136
  11. 11. This academic article was published by The International Institute for Science,Technology and Education (IISTE). The IISTE is a pioneer in the Open AccessPublishing service based in the U.S. and Europe. The aim of the institute isAccelerating Global Knowledge Sharing.More information about the publisher can be found in the IISTE’s homepage: CALL FOR PAPERSThe IISTE is currently hosting more than 30 peer-reviewed academic journals andcollaborating with academic institutions around the world. There’s no deadline forsubmission. Prospective authors of IISTE journals can find the submissioninstruction on the following page: IISTE editorial team promises to the review and publish all the qualifiedsubmissions in a fast manner. All the journals articles are available online to thereaders all over the world without financial, legal, or technical barriers other thanthose inseparable from gaining access to the internet itself. Printed version of thejournals is also available upon request of readers and authors.IISTE Knowledge Sharing PartnersEBSCO, Index Copernicus, Ulrichs Periodicals Directory, JournalTOCS, PKP OpenArchives Harvester, Bielefeld Academic Search Engine, ElektronischeZeitschriftenbibliothek EZB, Open J-Gate, OCLC WorldCat, Universe DigtialLibrary , NewJour, Google Scholar